Friday, September 30, 2011

Obama's Tax Proposals

I'm still a bit worked up about how Obama's tax plans were covered in the media. I just don't feel that Obama's positions were accurately presented or that the objections to them really reflected the plan itself. Instead, we were given a somewhat fantastical narrative about the plan that adhered more closely to traditional stories about the left and right than it does to actual policy positions that exist in the real world. Storytelling trumped facts yet again.

First, a bit that I favor but that is neither here nor there narratively. The plan includes an expiration of the Bush tax cuts on higher income earners. Looking over the last decade there's no real evidence they did much for growth so good riddance, but I admit this particular provision falls into the traditional story well enough. The thing is, the rest of the plan really doesn't.

The second thing I'll bring up is a provision I lean towards not liking but that doesn't really fit the traditional narrative. This is the proposal to limit the value of itemized deductions to 28% for families making more than $250,000.

There's a few notable things about this proposal. First off, it's complicated, which on its own is a good reason not to like it. It does weird things, like create a zone where families making $240,000 a year can still get a deduction worth 33 cents on a dollar where deductions for a family making $260,000 a year are worth only 28 cents on the dollar (admittedly ignoring some complications here). Most likely this won't do anything to alter incentives, a deduction is still worth 28 cents on the dollar and the reduction from 35 cents on the dollar won't make much difference. This will also balance incentives so that the person facing a 35% marginal rate will now have a similar incentive structure to someone at the 28% marginal rate lessening distortions due to differential impact between brackets.

On the whole, however, this is an ass backwards way of doing this and we'd be better off tackling more deductions so that we don't get as many distorting tax incentives.

Which is what I like about this plan. Most of the changes involve getting rid of distortionary tax incentives. This is particularly important because most of the tax literature indicates that most people* don't respond all that strongly to absolute changes in tax rates but respond very heavily to differences between tax rates. So while behavior won't be distorted a great deal by a change in the marginal tax rate it will be distorted heavily if there is a change in the capital tax rate relative to the income tax rate, in treatment of various income sources, or in deductions for various types of spending.**

A very big piece here is that carried interests/profits will now be treated as ordinary income. This tax treatment is particularly illustrative of the unfairness of the tax code and how it distorts behavior. By treating this form of income differently the tax code creates very large incentives for businesses to seek to classify employee compensation as carried interest rather than as ordinary income. This shifting is likely to be inefficient, businesses are doing this because it brings them a tax advantage, not because of market efficiency. By eliminating this deduction the plan will not only raise revenue but it will also reduce distortions in the economy. Eliminating loopholes such as this are pro-market under any definition of the market more sophisticated than market = private sector (which is unfortunately used all too frequently).

There are a number of other rules changes such as this, regarding oil and gas companies, life insurance companies, accounting rules, etc., some of them quite technical. On the whole, eliminating these loopholes should be efficiency increasing (in my opinion, very, very few loopholes are efficiency increasing and I believe their elimination would almost always benefit growth, the few exceptions can be better dealt with in many cases through spending rather than the tax code, well with some exceptions where the IRS would be more efficient at dispersing the spending but this is mostly for low income individuals rather than the high income exceptions discussed here). It needs to be more broadly recognized just how much variation there is in the current tax treatment of individuals. This variation is far more distorting and damaging to efficient allocation and economic growth than the absolute levels of taxation and spending, it is relative tax rates that matter not headline rates. Obama's plan is surprisingly good, though not perfect, at focusing on distortionary provisions of the tax code. More could be done, but it's a step in the right direction.

My biggest critique, really, is that there is no provision to cap the home mortgage interest deduction, which is an increasingly necessary reform. Wealth and the Welfare State referred to the American welfare state as V shaped for the amount of giveaways the rich receive, largely through the tax code. The mortgage interest deduction being the biggest of these, it should have been the first cut.

*Exceptions are basically artists and other who engage in piece work. High tax rates can and do make these individuals choose not to write another book, act in another movie, or give an additional talk or lecture. This is a small segment of the wealthy population however. A factory owner doesn't have the luxury of being able to shut his factory down halfway through the year because too much of his marginal income is being taxed away to be worth it. While we can argue on some esoteric philosophical plain about the implications of this, as a pragmatic, empirical matter there is little observable change in behavior based on absolute rates beyond those few that engage in high end piece work.

** While people don't change their behavior very much to changes in absolute rates changes in relative rates will cause individuals to hide their personal income as business income if taxes on capital are lowered relative to labor. This is surprisingly easy to do, though the easiest loopholes have been closed. It can also be seen in other areas, favorable tax treatment of housing causes people to invest more in housing relative to other assets than they otherwise would. This does, of course, break down once we are "out of sample," as Lindert said many times in his book. Truly confiscatory taxes, such as more than half of absolute, not marginal, production does tend to have very significant impacts on behavior. This, however, is almost never engaged in by states in modern times (it is, however, historically frequently engaged in by powerful private actors and is a recurrent theme throughout history, for instance, in China, taxes were generally set at 1/30 of the harvest in Han times, in additional to pole taxes which could also be problematic, but landlords would frequently take half the harvest, a recurrent historical theme, not just in China but in most agrarian societies, is that peasant revolts worsen as more peasants become beholden to private landowners rather than the state, there's no reason to believe this is unique to pre-modern societies, though we have no recent historical experiences of a modern state weak enough to allow this dynamic to develop over a long time frame).